Home > EMH, Monetary Policy, Recovery, Taxes, Uncategorized > What Do Markets Think of the Fiscal Cliff?

What Do Markets Think of the Fiscal Cliff?

28/Dec/2012

I’m not too worried about this fiscal cliff.  My guess is that it won’t even lead to a recession, if we do ‘go over’, but rather a marked slowing in RGDP for a quarter or so.  I think the economy would look as it did before QEII.

In a situation like this, the thing to do is to look at the markets to get a sense of what they foresee. However reading markets is not so straightforward in this situation. Unlike monetary policy, which is more or less neutral in its impact on the composition of aggregate demand (where the ‘money goes first’), fiscal policy is by definition nonneutral. If the government cuts the military’s equipment budget, then military contractors stand to lose more than others.

Because it is big corporations which stand to lose the most (or if you are an anoying libertarian, ‘their shareholders’) from the fiscal cliff, the stockmarket might be a less useful forecasting tool than bond yields or commodity prices. At least if your reference index is dominated by government-linked corporations.

graph

Oil prices and bond yields don’t look like they are discounting a recession. Oil prices (West texas intermediate) have held in the mid to high $80s while TIPS spreads and bond yields have been fairly steady. As of Friday afternoon, December 28 WTI front month contracts were trading around $90 and the ten year bond yield is at 1.71%.

If we would say that there is a 40% chance of taking on the full fiscal cliff, and that markets are already discounting this, I would say that the full fiscal cliff would not have the sort of disasterous consequences some fear. At least this is what the markets say to me.

Some regions would be hard-hit, but the recovery would survive.

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  1. 28/Dec/2012 at 20:04 | #1

    Excellent stuff! You are so very right!

  2. 29/Dec/2012 at 17:07 | #2

    Thanks Lars! I should add that I almost hope they botch the fiscal negotiations so we can find out what will happen…

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